How to build and preserve wealth investing in cash-flowing multifamily real estate

Commercial multifamily real estate investing offers a great opportunity to build wealth, both for passive investors and syndicators. In this article, we’ll touch on the advantages of investing in multifamily (including multifamily investing tax benefits), how to present an offer and raise capital, and the steps involved in finding, underwriting, and closing a deal.

Advantages of Commercial Multifamily Real Estate Investing

Multifamily real estate offers a number of advantages to investors.

• Cash flow
• Tax benefits 
• Lower risk
• Easier to manage
• Appreciation

Cash Flow

Multifamily real estate generally has better cash flow potential than single family real estate investments. For example, in a multi-unit apartment complex, there are numerous streams of rental income flowing in, compared to just a single monthly rent payment with a single family home. Having numerous units also keeps cash flow more consistent. If a single-family home becomes vacant, investors lose 100% of that rental income until the home is rented again, whereas an apartment building will rarely be completely vacant.

Tax Benefits

There are several potential tax benefits for multifamily real estate investing. Consult your accountant to see if you might benefit from any of these multifamily real estate tax advantages.

• Real estate depreciation deduction - Multifamily real estate investors can claim a depreciation deduction on their investment. The IRS sets the “useful life” of a multifamily property at 27.5 years. To calculate the deduction, divide the value of the property by [number of years]. This is the amount that you can deduct from your taxes each year.

• Cost segregation - Cost segregation allows investors to take advantage of the different lengths of “useful life” (5, 7, or 15 years) for various property-related costs, breaking them down into categories such as electrical systems, plumbing, sidewalk construction, light fixtures, etc. Getting a cost segregation analysis is not cheap, but it could potentially pay for itself (and then some) through higher tax deductions. 

• Bonus depreciation - The 2017 Tax Cuts and Jobs act increased the allowable first-year bonus depreciation from  50% to 100%. This means that in the first year of owning a multifamily property, investors can deduct up to 100% of qualified expenses. These qualified expenses are limited to assets with a useful life of less than 20 years, so they do not include the value of the multifamily property itself. However, it can be applied to certain expenses when using cost segregation. Note that the current 100% bonus depreciation rate is scheduled to start phasing down in 2023 to 80%, and then dropping 20% each year until it is phased out completely in 2027.

• Depreciation recapture - It is important to note that when you sell your multifamily investment, the sale will be subject to depreciation recapture. While a portion of the gains will be taxed at the long-term capital gains rate, depreciation deductions will be taxed at your higher personal tax rate.

• 1031 exchange - A 1031 exchange allows investors to roll their capital gains from the sale of one property into the purchase of another one, tax-free.

• Long-term capital gains tax - Generally speaking (with one notable exception being depreciation recapture), gains from multifamily real estate investments are taxed at the long-term capital gains tax rate, which is lower than the standard individual tax rate.

Less Risk

Commercial multifamily real estate investing is considered to carry less risk than other types of real estate. One reason for this is its fairly consistent rental demand. While the demand for single-family homes, offices, and retail properties tends to fall during economic downturns, leading to higher vacancy rates, the demand for residential rental properties typically stays strong, or even increases.

And, when someone moves out of an apartment, that only creates a vacancy in one of the numerous units in the property, whereas when someone moves out of a single-family house the vacancy rate is 100%. This means a smaller risk of periods with no cash flow.

Additionally, multifamily real estate includes a variety of property types, including large apartment buildings, duplexes, and communities geared toward retirees. This diversity can further lower the risk of investing in multifamily real estate.

Easier to Manage

While managing a multifamily real estate property is complex, bundling numerous units together in one place actually makes it easier than managing a portfolio of single-family homes.

For one thing, even if an apartment building has 50 units, there is only one bank loan. Compare this to separate loans for each single-family property. A single insurance will also cover the individual units. And, if you need to replace an old roof, doing so would effectively replace the roof for 50 different streams of rental income all at once.

Multifamily properties also make hiring a property manager a cost-effective way to make managing the property even easier. Single-family homes often don’t bring in enough income to make hiring a property manager worth it, leaving you stuck managing the properties yourself.

Appreciation

While single-family homes often have the potential to appreciate in value more than multifamily properties, multifamily real estate tends to be more resilient to down markets, offering a slow but steady increase in value over the long term — all while bringing in impressive monthly cash flow.

Finding a Deal and Due Diligence

CRE broker and investor Jon Hegwood’s Strategies to Find Properties for Investing in Real Estate and A Comprehensive Approach to Real Estate Deal Due Diligence articles do a great job of covering some details about finding multifamily properties and performing due diligence on potential deals.

Some of the best places to find real estate investment properties are through:

• Brokers
• Online marketplaces
• Online property databases
• Industry organizations
• Networking
• Lenders with foreclosures
• Prospecting

Once you’ve found a potential deal, the following steps will help you decide if it is worth pursuing or if it is best to let this one go and move onto the next one:

• Establish a deal team - property manager, attorney, lender
• Financial due diligence - rent roll, vendor contracts, historical analysis, market analysis
• Physical due diligence - third-party inspection, title & survey reports, environmental, appraisal/property condition report
• Operational due diligence - taking a look at the information uncovered in the previous steps along with the property’s current operations and opportunities for improvement, and then determining how the property fits with your investment strategy and capital budget

For a deeper dive on these points, make sure to check out the articles linked above.

How to Raise Capital

Once the general partner has found the right multifamily property for their syndicate, it’s time to raise capital. If this is their first deal, ideally the syndicator will have at least started networking with potential investors, educated them about multifamily real estate syndication, and gauged potential interest in future investment opportunities. This will help make raising the required funds less of a scramble.

Who Can Invest in Real Estate Multifamily Syndication?

Rule 506(c) of Regulation D allows multifamily syndicators to publicly advertise and solicit investments for properties, as long as they only accept investments from accredited investors. This updated guide provides detailed information about who qualifies as an accredited investor under the latest definition changes from the SEC. 

Present the Offer

When presenting the offer to prospective investors, there are several things you want to make sure you include.

First, if reaching out by email, having an eye-catching subject line is key. You want to keep it fairly brief, but it should also include specifics about the deal that will help the email stand out from the many others that the investor receives each day.

Next, start off the email with a brief description of the highlights of the deal, including photos. This section should be interesting enough to grab the investor’s attention but short enough to keep it.

From here, get into more of the specifics about the projected returns as well as the profit split and fees. There are a few ways a syndicator can structure the profit split.

• Straight split - This is the simplest profit split structure. Here, profits are simply split between the general partner and limited partners in a set ratio. For example, 80% for the LPs and 20% for the GP.

• Preferred return - A preferred return profit split pays out a certain percentage return to the LPs before the GP sees any profit. Once the preferred return amount is met, the structure changes to a straight split. This structure can help attract investors, as it lessens their risk and helps build trust between them and the syndicator.

• Waterfall - A waterfall profit split has various tiers, with the split structure changing as various milestones are met. For example, it could start off with a preferred return for investors, then change to an 80/20 split until certain return thresholds are met, and then change to a 60/40 split going forward. 

The best profit split structure for syndicators when attracting investors will depend on the specifics of the multifamily property, as well as the syndicator’s personal track record and current market trends.

Along with the structure of the profit split, the offer presentation should include the syndication’s fee structure. The following is not an exhaustive list, but it includes some of the most common syndicator fees.

• Acquisition fee - This is probably the most common multifamily real estate syndication fee. It is a one-time fee that is typically about X% of the purchase price of the property.

• Asset management fee - This is typically either a percentage of revenue or a per-unit flat fee. It can include a construction management fee for improvements made to the property.

• Refinance fee - This fee is paid for the work involved in the event that the syndicator refinances a multifamily property.

• Loan guarantor fee - This fee is used to offset the risk the syndicator (or other investor) takes on if they sign as a guarantor on the loan.

• Disposition fee - A fee that is paid when the property is sold.

Managing a Real Estate Multifamily Syndication

A syndicator’s job isn’t over once the deal closes. Whether they employ a dedicated asset manager or handle it themselves, the general partner is ultimately responsible for the following things after acquiring a multifamily real estate investment property:

• Keeping LPs updated.- Syndicators should make sure to communicate with investors on a regular basis to keep them up to date on how their investment is performing. This includes sending out monthly updates and quarterly financial reports as well as being responsive to any questions they may have.

• Completing back office tasks - Having sufficient insurance coverage, opening and maintaining bank accounts, ensuring that permits and other paperwork are all in order, and other administrative tasks all need to be done properly.

• Sending tax documents to LPs - GPs need to send K-1s to investors each year. There are a few different options for how to do this.

• Managing the property manager - Regularly communicating with the property manager to stay on top of any issues that arise and make sure they are doing their part in boosting occupancy is crucial.

• Staying informed about the market - Market conditions change, and it is important to be aware of current and projected trends to set optimal rents and know when it might be the right time to start considering selling.

• Selling the property - The timeline will depend on the investment strategy and market conditions, but eventually the syndication is likely to sell the property.

Each of these is critical for making sure the investment is successful and for building and maintaining investor trust, which will ultimately boost the syndicator’s reputation and help with future deals.

Building and Preserving Wealth With Multifamily Real Estate: In Closing

A syndicator who can find the right investment property, raise enough capital, and then effectively manage the investment will start to develop a solid track record, which in turn will attract more investors and open the doors to more multifamily investment opportunities. 

These types of properties are some of the best ways to build and preserve wealth. The consistent cash flow from multifamily properties and the tax benefits that come with them are big advantages over some other asset classes, and the relatively lower risk and steady appreciation keep the investment safe and growing over the long term.